A recent accounting clarification could have big implications for managing LOBO loans. David Green suggests there is a way to save councils from going under.
Many local authorities had objections raised to their accounts in 2016 and 2017 in relation to “lender’s option, borrower’s option” (LOBO) loans by debt campaigners. The majority of these objections had no lasting effect, but it did bring “inverse floater” LOBOs to the auditors’ attention.
A number of these audit firms subsequently wrote to the CIPFA/LASAAC accounting code board, prompting it to issue a clarification statement about embedded derivatives in May this year. This clarification is having a real multi-million impact on the bottom line of a small number of local authorities.
Since the adoption of IFRS-style financial instrument accounting in 2007, the accounting code has always ruled that the options embedded into local authorities’ LOBO loans can effectively be ignored for accounting purposes until they are triggered.
The recent clarification statement points out that this ruling only applies to embedded options, and that where local authorities have other derivatives embedded into their loans, the usual IFRS rules apply.
Around ten local authorities have borrowed LOBO loans with a variable interest rate. But unlike normal variable rates that move in line with market rates, the interest on these loans moves in the opposite direction; for example, they might be paying 9% minus the market rate.
This is an inverse floating derivative and must be tested according to specific IFRS rules as to whether it needs to be accounted for as a separate financial instrument. The distinction is important, as derivatives are always held at fair value or “marked to market”, and given the steep fall in interest rates since the loans were borrowed, these derivatives are now a large cost to the authority.
Tests
One of the tests for separation in IFRS is whether the derivative enables the lender to double their initial rate of return.
Market rates on the loan start date are therefore very important; if the market was 5% then the initial rate of return was 4% and this could be doubled to 8% if market rates fall to 1%. This is clearly quite possible. In fact, after the EU referendum in 2016 the market rates in question fell to lows of around 0.5%.
But if the market rate on the start date was 3%, then the initial rate of return was 6% and this can only be doubled to 12% if the market rate falls to minus 3%.
This has led a couple of authorities to have philosophical arguments with their auditors about the realistic prospects of negative interest rates in the UK. While mathematically possible, I suggest such an event is unlikely enough not to drive accounting decisions.
There are added complications though. Some loan contracts specify a maximum rate that can be paid — say, the 9% in our example — which explicitly prevents the initial rate being doubled if the market rate started below 4.5%.
Many loans had low “teaser” rates for a couple of years at the start, which affects the calculation of the initial rate of return. And a few loans have been renegotiated, requiring a separate accounting test for modification and extinguishment.
Lifeline
What is the impact of all this? Well, the affected authorities have between £10m and £150m of inverse floating loans each, and the value of the embedded derivatives is around 60–70% of the loan principal, in the bank’s favour. So, to show these in their accounts at fair value, one authority would have to charge a nine-figure sum to revenue; to recover that sum in a single year would mean doubling council tax.
There is a lifeline though for any authority in danger of drowning. By repaying the loans early, or restructuring them into fixed rate products, the embedded derivative disappears and the multi-million pound accounts charge is reversed.
There may be a premium payable to the bank, but regulations already exist in England and Wales that permit premiums to be spread over the remaining life of the loan repaid, which in these cases is at least 40 years.
LOBOs are causing accounting headaches for banks too, so you should be able to negotiate a premium that works for both parties. It’s too late to do that for 2017–18, so expect to see a few headlines when final accounts are published in July, but action can be taken in 2018–19 to limit the long-term impact.
David Green is
strategic director
at Arlingclose Limited.
